Customer Protections for Cleared Interest Rate Swap Trades under Trust Arrangement (Comparison between JSCC rules and CFTC regulations)

JSCC CFTC

1 Segregation

of

Customer

Collateral

Customer collateral is deposited at JSCC and is held in each

customer’s individual segregated account which is segregated

from (i) JSCC’s own assets, (ii) the clearing members’ collateral,

and (iii) the fellow customers’ collateral. Deposit with and

withdrawal from JSCC of customer collateral is made by

customers through a clearing broker acting as the payment

agent.1

Business Rules2

Articles 59.2,

75, 76.4 and

87.1

Financial

Instruments

and Exchange

Act of Japan

Article 156-113

Customer money, securities and property

(“customer property”) must be legally

segregated from that of other customers, the

FCM and the DCO, but customer property

may be held by a DCO or FCM in an

operationally commingled account with the

collateral of all customers.

CFTC Rules 22.3,

22.15, 39.15, 39.16

CEA Section 4d(a)

and 4d(b)

CEA Section 5b(f)

1 A defaulting clearing broker cannot act as an agent, and in such a case, a customer can request return of their collateral directly from JSCC.2 Article 156-7.1 of Financial Instruments and Exchange Act of Japan (“FIEA”) requires central counterparties (“CCPs”) to operate their clearing business pursuant to their business rules. Article 156-12 of FIEA requires the JFSA’s approval for changes to business rules. JSCC’s rule books for the IRS clearing are available at JSCC website (https://www.jpx.co.jp/jscc/en/rule/rule_irs.html).3 JSCC maintains the segregation of customer collateral in accordance with the collateral segregation requirements under the FIEA regime (Article 156-11 of FIEA, Article 18 of Cabinet Office Order on Financial Instruments Clearing Organization) and the JFSA’s Comprehensive Guidelines for Supervision of Financial Market Infrastructure (“JFSA Guidelines”) (III-3-6 ).

An English translation of Cabinet Office Order on Financial Instruments Clearing Organization is available on the Ministry of Justice website: (http://www.japaneselawtranslation.go.jp/law/detail/?ft=1&re=01&dn=1&ia=03&co=01&x=0&y=0&ky=%E9%87%91%E8%9E%8D%E5%95%86%E5%93%81%E5%8F%96%E5%BC%95%E6%B8%85%E7%AE%97%E6%A9%9F%E9%96%A2&page=4).

An English translation of JFSA Guidelines is available on the JFSA website: (https://www.fsa.go.jp/en/news/2014/20140327-1/01.pdf)1

The purpose of this document is to provide a high-level summary comparison of certain elements of the customer collateral protection regimes applicable to cleared interest rate swaps under (1) the rules of JSCC and related Japanese law and (2) certain aspects of U.S. law, including the Commodity Exchange Act, CFTC regulations and the U.S. Bankruptcy Code. This document is purely for illustrative purposes and intended to facilitate discussion. The contents of this document are not, and are not intend to be, complete or comprehensive descriptions of the regimes and are subject to ongoing revision.

JSCC CFTC

2 Bankruptcy

Remotenes

s of

Customer

Collateral

JSCC has established a trust arrangement whereby the customer

collateral is deposited in accounts on behalf of customers (the

“Trust Accounts”).4 The collateral in the Trust Accounts is legally

remote from a bankruptcy of (i) JSCC, (ii) clearing members, and

(iii) the trust bank.

Article 25 of the Trust Act of Japan5 is construed as the legal

basis for the bankruptcy remoteness of collateral in the Trust

Accounts from the trustee’s assets. JSCC has obtained a legal

opinion from an independent law firm (Linklaters Tokyo6)

concerning the bankruptcy remoteness of the collateral in the

Trust Accounts from JSCC’s bankruptcy estate in cases of JSCC's

insolvency.

Fees and costs arising from the trust arrangement, if applicable,

would be passed onto clearing members by JSCC7 and would not

be deducted from the customers’ collateral.

Business Rules

Article 87.1

Handling

Procedures

Articles 44.2

and 44.3

Trust Act of

Japan, Article

25

FCMs and DCOs must segregate customer

property from other assets. In the case of an

FCM bankruptcy, customer property is entitled

to priority under the U.S. Bankruptcy Code and

the CEA and will be paid to customers before

any property becomes available to satisfy

claims of an FCM’s other customers.

U.S. Bankruptcy

Code, Section 766

CFTC Rule 190.08

4 Alternatively, clearing members and customers may elect to custody their own JPY cash collateral at the Bank of Japan. This document describes the protections when choosing the trust arrangement.5 An English translation of the Trust Act is available at the Ministry of Justice website, here: (http://www.japaneselawtranslation.go.jp/law/detail/?id=2476&vm=04&re=01)6 The official name is Gaikokuho Kyodo-Jigyo Horitsu Jimusho Linklaters.7 JSCC passes the fees and costs to the special clearing fees.

2

The purpose of this document is to provide a high-level summary comparison of certain elements of the customer collateral protection regimes applicable to cleared interest rate swaps under (1) the rules of JSCC and related Japanese law and (2) certain aspects of U.S. law, including the Commodity Exchange Act, CFTC regulations and the U.S. Bankruptcy Code. This document is purely for illustrative purposes and intended to facilitate discussion. The contents of this document are not, and are not intend to be, complete or comprehensive descriptions of the regimes and are subject to ongoing revision.

JSCC CFTC

3 Treatment

of

Customer

Collateral in

the Event of

a JSCC,

Trust Bank

or Clearing

Broker

Bankruptcy

Should JSCC go bankrupt, the trust bank would return customer

collateral directly to each customer, in accordance with the

payment instructions provided by an independent attorney at

law, who is appointed in advance as part of the trust

arrangement and acts as an agent for all of the customers.

Should the trust bank default, or its creditworthiness deteriorate,

JSCC may substitute another trust bank. The procedure for this is

detailed in the trust agreement.

If a clearing member defaults, the customers of the defaulting

member may port their positions and collateral, which are held

in each customer’s individual segregated accounts at JSCC, to

brokerage account(s) held by non-defaulting clearing

member(s).

Customers must obtain the prior consent from the non-

defaulting clearing member(s) to which they wish to port

their positions.

The application for porting must be submitted within two

(2) business days from the clearing member’s default.

Business Rules

Articles 76.1(1)

(a), 76.4, 94.1

and 94.3

Rules on

Default

Settlement,

Articles 8.1

and 8.2

Financial

Instruments

and Exchange

Act of Japan

Article 156-11-

2.1

The customer of an insolvent FCM is afforded

priority over other creditors of the FCM in the

distribution of the FCM’s customer property.

If an FCM defaults, the DCO will generally

transfer the cleared positions of the FCM’s

non-defaulting customers to another FCM.

If an FCM defaults, the trustee, the DCO or

the FCM must notify the CFTC whether such

entity intends to transfer open customer

positions to another FCM.

The trustee will inform the Bankruptcy Court

of customer positions and collateral to be

transferred by the DCO as part of a bulk

transfer to another FCM. Once approved by

the Bankruptcy Court, the DCO is free to

transfer customer positions and collateral in a

single bulk transfer.

Subchapter IV of

Chapter 7 of the

U.S. Bankruptcy

Code

Part 190 of the

CFTC Regulations

(CFTC Rules

190.02, 190.06)

CFTC Rule 39.16

3

The purpose of this document is to provide a high-level summary comparison of certain elements of the customer collateral protection regimes applicable to cleared interest rate swaps under (1) the rules of JSCC and related Japanese law and (2) certain aspects of U.S. law, including the Commodity Exchange Act, CFTC regulations and the U.S. Bankruptcy Code. This document is purely for illustrative purposes and intended to facilitate discussion. The contents of this document are not, and are not intend to be, complete or comprehensive descriptions of the regimes and are subject to ongoing revision.

JSCC CFTC

However, in certain circumstances, JSCC can extend the

application deadline by up to four (4) additional business

days.

No court approval is required.

If the clearing member defaults, customers also have the option

to claim directly to JSCC for the return of their customer

collateral. JSCC would return customer collateral directly to each

customer, after deducting the outstanding amount of

obligations that arise from the customer’s own swap trades.

Generally, customer accounts that are in

deficit are not included in a bulk transfer and

will be liquidated. If the DCO is unable to do

so, the DCO will unwind the defaulting FCM’s

customer positions.

Any remaining collateral will be distributed

per the trustee’s instructions.

If a CCP defaults, it would be subject to the

same regime described above for FCMs.

4. Delivery of

Customer

Collateral to

the Trust

Bank

Customer collateral is delivered to JSCC or the clearing member

(as payment agent) via such entity’s BOJ account. Such

customer collateral is at all times segregated (as described

above). During the very brief period in which the customer

collateral remains at the BOJ, subject to transit to the trust bank,

such collateral is not bankruptcy remote.

However, the period of time in which customer collateral is

subject to this transit process can be effectively managed by the

Business Rules

Articles 63(2),

66.1, 70.1,

72.1 and 72.2

Handling

Procedures

Article 43.2

Customer funds are at all times legally

segregated from the funds of other customers

and the proprietary funds of the DCO or FCM

and are afforded priority under the U.S.

Bankruptcy Code.

U.S. Bankruptcy

Code and Part 190

of the CFTC

Regulations

4

The purpose of this document is to provide a high-level summary comparison of certain elements of the customer collateral protection regimes applicable to cleared interest rate swaps under (1) the rules of JSCC and related Japanese law and (2) certain aspects of U.S. law, including the Commodity Exchange Act, CFTC regulations and the U.S. Bankruptcy Code. This document is purely for illustrative purposes and intended to facilitate discussion. The contents of this document are not, and are not intend to be, complete or comprehensive descriptions of the regimes and are subject to ongoing revision.

JSCC CFTC

customer or its agent, since (i) clearing members are required by

JSCC rules to deliver all customer collateral to JSCC8 without

delay and by the deadline of each margin call (11:00 and 15:30),

and (ii) the exact time (11:30, 15:30 and 16:30)9 at which JSCC

delivers customer collateral to the trust bank are prescribed.

Thus, if a customer delivers collateral to its clearing member

immediately before the prescribed time, the time period in

which the collateral remains in transit during the settlement

process can be shortened, which would mitigate the risk of loss

to the customer due to a bankruptcy of JSCC.

8 This can be exempted if the clearing member obtains the customer’s consent. In such a case, the clearing member must deliver to JSCC the substituted collateral (i.e. eligible collateral that is different from the collateral originally delivered to the clearing member) in an amount not less than the value of the collateral originally received from the customer (Article 73.1 and 73.2 of the Business Rules).9 These deadlines are prescribed in the operational procedures that are distributed to all clearing members.

5

The purpose of this document is to provide a high-level summary comparison of certain elements of the customer collateral protection regimes applicable to cleared interest rate swaps under (1) the rules of JSCC and related Japanese law and (2) certain aspects of U.S. law, including the Commodity Exchange Act, CFTC regulations and the U.S. Bankruptcy Code. This document is purely for illustrative purposes and intended to facilitate discussion. The contents of this document are not, and are not intend to be, complete or comprehensive descriptions of the regimes and are subject to ongoing revision.